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Hong Kong's Disclosure Based Regulatory Regime Takes Further Shape

27 February 2009

Mayer Brown JSM Legal Update

On 17 February 2009, the Securities and Futures Commission postponed the implementation date of its revised advertising guidelines and enhanced disclosure requirements in relation to the content of existing marketing materials in respect of collective investment schemes to 1 July 2009 to give certain issuers more time to implement these measures. Meanwhile, the December 2008 reports by the Securities and Futures Commission and the Hong Kong Monetary Authority to the Financial Secretary in relation to issues raised by the Lehman minibond saga remain under discussion.

By way of background, the existing regulatory regime for retail investors in collective investment schemes is set out in the Securities and Futures Ordinance and various product codes and circulars, for example, the SFC's Code on Unit Trusts and Mutual Funds and Code on Real Estate Investment Trusts. In addition to various other guidelines , letters and FAQ's, informal guidance as to what the SFC expects is also evident from investor education materials, for example, the risks of investing in guaranteed funds are highlighted in 'When is a guarantee, not a guarantee?' - the message is that a guaranteed fund may not be equivalent to principal protection as the guarantee may be conditional - a guaranteed fund is not free of risk.

The existing regulatory regime for retail investors in structured notes in Hong Kong rests on a 'disclosure' based regime which obliges the authors of offering documentation to comply with the disclosure requirements of the Companies Ordinance and to disclose the pro's and con's of the investment opportunity to enable investors to make an informed decision. Hence, the inclusion of risk factors in offerings of retail structured notes such as below,

... you are exposed to the credit risk of [names of reference entities] and also of [ABC Bank] with whom the Issuer intends to enter into a credit default swap agreement ...

Disclaimers by regulators such as the 'authorisation of this investment is not a recommendation, nor an endorsement, of the investment' are commonly seen in 'disclosure' based regimes.

On the other hand, a 'merit-based' regime requires the investment merits of the offering to be assessed by a regulator. If, following such review, the regulator is of the view that the offering is too complex for retail investors to understand or too risky or otherwise does not merit a retail offering, then the offering will be prohibited or the regulator may require changes in the structure of the product being offered. Accordingly, the responsibility for determining whether an investment opportunity is suitable for retail investors is placed on the applicable regulator.

The second element of Hong Kong's so called two pillars approach is a 'suitability' requirement, on the part of the selling intermediary of structured notes and collective investment schemes, to determine the suitability of the investment for its client , as required by the SFC's Code of Conduct for Licensed Persons and in particular, the 'six suitability obligations' of investment advisers identified by the SFC. Hence, the SFC's letter to intermediaries dated 17 February 2009 again urges more training to be provided to sales staff and distributors so that, at the point of sale, they have the ability to communicate the features and associated investment risks of the products to both existing and new investors.

Regulators in Hong Kong also encourage announcements by listed companies to include boxed summaries and offering documents to be written in plain English (for example, the SFC's "How to create clear announcements" and "How to create a clear prospectus" appear on its website). Beyond Hong Kong's regulatory regime, Europe's UCITS III regime for collective investment schemes has seen the introduction of simplified prospectuses which are made available in conjunction with full length versions. In practice, simplified prospectuses have not met expectations, as they are often lengthy, and in different formats, making comparisons between competing investment opportunities difficult. UCITS IV, which was adopted by the European Parliament on 13 January 2009 with a view to implementation no later than July 2011, envisages replacing the concept of a simplified prospectus with a standardised four page ‘key investor information’ document.

Outside the regulated space and in the context of private placements, sophisticated investors are typically left to make their own determination whether or not to invest, based on the disclosure made to them. However, sometimes even sophisticated investors can ignore material risks disclosed to them. For example, recent cases suggest investors in feeder funds, which invested in managed accounts, failed to attach significance to the risk factors like those below,

There is the risk that the broker-dealer could abscond with the monies entrusted by us. There is always the risk that the investments made on our behalf by the broker-dealer could be misappropriated.

In addition, information supplied by the broker-dealer may be inaccurate or even fraudulent. We are not required to undertake any due diligence to confirm the accuracy thereof.

The most important feature of the SFC's enhanced disclosure guidelines is the requirement to include a bullet pointed risk disclosure box, appearing upfront or elsewhere, as long as it is prominent in offering documents and advertising pamphlets to alert investors to the main features, worst case scenario and 'very key' risks of the investment opportunity. The dense packing of diverse information into a complex sentence or a long paragraph is to be avoided. Investors must be reminded not to invest unless the sales person has explained that the investment is suitable and why it matches their risk/return profile. Presenting the 'pro's' of the investment opportunity disproportionately to the 'con's' or highlighting related benefits like a free iPod may also be unfair to potential investors.

As marketing materials take many forms in different media, a lot of effort is being undertaken to adapt the guidelines to suit each form of marketing. These efforts will certainly result in greater clarity in Hong Kong for both distributors and investors alike. However, no amount of effort can result in a bullet proof investment opportunity.

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